Monthly Archives: September 2010

Whenever economists are asked why they love markets, they inevitably respond that “markets lead to prosperity” or that “markets efficiently allocate resources” or some other such answer than one could find by reading a textbook. What I love about markets is sometimes mundane (I love one-size-fits-all soft drink lids, for example) and other times technologically impressive. In other words, what I especially love about markets is the innovation that they inspire. I was reminded of this reading the WSJ this morning:

For more than 100 years, researchers have tried to come up with adjustable eyeglasses; a Baltimore inventor filed a patent on the idea in 1866. But a workable product that’s easy to adjust, thin, lightweight and accurate proved elusive.

Stephen Kurtin, a California inventor who previously devised one of the first word-processing programs, turned to the problem in the early 1990s. His solution, TruFocal eyeglasses, mimic the way that the lens of the human eye stretches and contracts to adjust focus.

[…]

Once the TruFocal lenses are adjusted, the entire field of vision is in focus, unlike bifocals and progressive lenses, which keep only a limited area in sharp focus. So a user can adjust the glasses to focus only on the book he’s reading, then look up and readjust them to focus solely on the TV across the room.

A common theme among those who de-emphasize the role of monetary policy in the creating the housing boom and ultimate bust is that the story doesn’t apply outside the United States. In other words, how do we explain housing booms in other countries? The policy European Central Bank, for example, is not perceived by some observers to be as loose as that of the Federal Reserve.

On this point, however, I wondered whether this was correct. For example, policy rates for the Eurozone may have different effects on different members. Specifically, regarding Ireland, I wrote:

I have found the Irish experience of the worldwide recession to be one of the most intriguing. From 1990 up until the beginning of the recession, the Irish economy grew over four-fold. However, since the recession began the economy has contracted by almost 20%. Part of my interest in Ireland is due to the fact that with the economy growing as rapidly as it did during its “Celtic Tiger” phase, rising productivity should have put downward pressure on prices. However, Ireland uses the Euro as its currency. As a result, it is possible (likely?) that monetary policy was comparatively loose in Ireland compared to other European Union members. Thus, if monetary policy became tight following a negative aggregate demand shock, this could potentially explain — at least in part — why the contraction was so severe in Ireland as one would expect to see a number of projects financed as a result of loose monetary policy fail.

Thus, the question is whether monetary policy played any role in the downturn.

A tangentially related new working paper by Angela Maddaloni and José-Luis Peydró might provide an answer as to the mechanism through which monetary policy could produce differing effects across countries. The paper focuses on deviations of monetary policy from the Taylor rule across countries in the Euro Area. Here is the abstract:

We analyze the root causes of the current crisis by studying the determinants of bank lending standards in the Euro Area using the answers from the confidential Bank Lending Survey, where national central banks request quarterly information on the lending standards banks apply to customers. We find that low short-term interest rates soften lending standards for both businesses and households and, by exploiting cross- country variation of Taylor-rule implied rates, that rates too low for too long soften standards even further. The softening is over and above the improvement of borrowers’ creditworthiness and all the relevant lending standards are softened, thus implying that banks’ appetite for (loan) risk increases. In addition, high securitization activity and weak banking supervision standards amplify the positive impact of low short-term interest rates on bank risk-taking, even when we instrument securitization. Moreover, short-term rates – directly and in conjunction with securitization activity and supervision standards – have a stronger impact on bank risk-taking than long-term interest rates. These results help shed light on the origins of the current crisis and have important policy implications.

I believe David Beckworth would refer to this as the risk-taking channel of monetary policy.

Alberto Alesina has an op-ed in the WSJ today summarizing results from his research on fiscal adjustments:

My colleague Silvia Ardagna and I recently co-authored a paper examining this pattern, as have many studies over the past 20 years. Our paper looks at the 107 large fiscal adjustments—defined as a cyclically adjusted deficit reduction of at least 1.5% in one year—that took place in 21 Organization for Economic Cooperation and Development (OECD) countries between 1970 and 2007.

According to our model, a country experienced an expansionary fiscal adjustment when its rate of GDP growth in the year of the adjustment and the next year was in the top 25% of the OECD. A recessionary period, then, was when a country’s growth rate was in the bottom 75% of the OECD.

Our results were striking: Over nearly 40 years, expansionary adjustments were based mostly on spending cuts, while recessionary adjustments were based mostly on tax increases. And these results would have been even stronger had our definition of an expansionary period been more lenient (extending, for example, to the top 50% of the OECD). In addition, adjustments based on spending cuts were accompanied by longer-lasting reductions in ratios of debt to GDP.

In the same paper we also examined years of large fiscal expansions, defined as increases in the cyclically adjusted deficit by at least 1.5% of GDP. Over 91 such cases, we found that tax cuts were much more expansionary than spending increases.

How can spending cuts be expansionary? First, they signal that tax increases will not occur in the future, or that if they do they will be smaller. A credible plan to reduce government outlays significantly changes expectations of future tax liabilities. This, in turn, shifts people’s behavior. Consumers and especially investors are more willing to spend if they expect that spending and taxes will remain limited over a sustained period of time.

On the other hand, fiscal adjustments based on tax increases reduce consumers’ disposable income and reduce incentives for productivity.

Much of the U.S. policy response to the crisis has been driven by a determination to learn from Japan: the Troubled Asset Relief Program and bank stress tests were designed to keep credit flowing. The Federal Reserve’s near-zero interest rates and bond purchases, and both the Bush and Obama administrations’ fiscal stimulus plans, were meant to sustain demand while the private sector pays down debt.

These have been the right actions. Yet they too narrowly focus on the role of inadequate demand in Japan’s reversal of fortune. Japan has just as important a lesson about supply.